The taxpayer has filed its answering brief in Container (attached below), arguing that guarantee fees paid to its Mexican parent were properly analogized to a payment for services and therefore sourced to Mexico. The taxpayer reasons that the government’s analogy to interest on a loan is misdirected because the guarantor does not advance any funds. All it does is “stand[ ] by to pay,” which is in the nature of a service, and it is the Mexican parent’s assets – located in Mexico – that give it the ability to serve as a guarantor. The taxpayer also maintains that the government’s position conflicts with the Tax Court’s factual findings to the extent that the government argues that the parent was a lender in substance because it expected the U.S. subsidiary to default.

The taxpayer disputes the government’s assertion that the relevant precedents support the interest analogy. With respect to the commissions paid for letters of credit in the Bank of America case, the taxpayer argues that “Bank of America was not being paid for substituting its credit for that of the foreign bank, but for substituting its money.” Accordingly, the taxpayer reasons, the commissions in Bank of America were logically analogized to interest, but a different result is called for in Container where the guarantor did not furnish any money. The taxpayer also distinguishes the Centel decision involving stock warrants as resting on factual findings specific to that case. It further contends that the Fifth Circuit should disregard the observation in Centel that Bank of America rejects analogizing guaranties to services, because that observation is “both dicta and incorrect.”

On October 15, 2010, the government filed its reply brief in TIFD III-E Inc. v. United States, No. 10-70 (2d Cir.) (“Castle Harbour”). The brief is linked below. For our prior coverage of the case, see here and here.

In its reply, the government contends that I.R.C. section 704(e)(1) is inapplicable to the facts of the case, and that the provision only applies in the family partnership context, where parties are related. The government asserts that section 704(e)(1) was not intended to apply, and indeed has never before been applied (and upheld) to an arm’s length transaction between two or more corporate entities.

Even assuming section 704(e)(1) applies, the government argues that the Dutch banks did not possess “capital interests” under the statute, because “capital interests” are legally equivalent to bona fide partnership interests, which the Second Circuit has already determined the Dutch banks did not possess. In essence, the government argues that the test under section 704(e)(1) is the same as the test under Commissioner v. Culbertson, 337 U.S. 733 (1949), and the Second Circuit having made its determination under that test, it is now law of the case that the Dutch banks did not have “capital interests.”

On a similar tack, the government also argues that under the facts of the case, the banks did not possess capital interests in the purported partnership. The government attempts to rebut the taxpayer’s fact arguments by arguing that a number of these fact issues were previously considered by the Second Circuit, with the court rejecting them as support for the conclusion that the banks had a meaningful equity participation in the partnership.

With respect to section 704(b), the government asserts that the taxpayer’s discussion of 704(c) is a red herring, and that the section 704(b) substantial economic effect test requires that tax results follow economic results; i.e., tax benefits and burdens must coincide with the related economic benefits and burdens. The government argues that the transaction at issue plainly fails that test: the taxpayer received $288 million of the partnership’s actual income, but only paid tax on $6 million. Meanwhile, the Dutch banks received $28 million of the partnership’s actual income, but were allocated $310 million of it.

The government also reiterates its position regarding penalties: the District Court’s misconstruction of the facts and misapplication of the law do nothing to abrogate asserted penalties, and that the taxpayer really did not have substantial authority for its return position.

In our initial post on the Mayo Foundation case pending in the Supreme Court, which concerns whether medical residents are exempt from FICA taxation, we noted that the case potentially raised a broad question that has surfaced in the courts of appeals and the Tax Court in recent years — namely, whether Chevron deference principles have supplanted the traditional Muffler Dealers approach to analyzing the deference owed to Treasury regulations. Although that issue was not flagged by the parties at the certiorari stage, we later observed that the taxpayers’ opening merits brief served that ball into the government’s court by relying heavily on some of the Muffler Dealers factors that are not ordinarily part of the Chevron analysis. The government has now responded by directly challenging the continuing vitality of Muffler Dealers. (The government’s brief is attached below.) As a result, there is a good chance that the Supreme Court will address the question and resolve the disagreement between the Tax Court and some courts of appeals on the proper analysis of deference to Treasury regulations.

The government’s brief does not mince words. It states that Muffler Dealers “has been superseded by Chevron” and therefore “the considerations on which [taxpayers] rely are largely irrelevant.” In particular, the government identifies three Muffler Dealers factors relied upon by the taxpayers that are allegedly irrelevant under Chevron: (1) “the recency of [the] adoption” of the regulation; (2) that the new regulation “was enacted ‘to overturn judicial decisions’ interpreting the student exemption”; and (3) that “Treasury’s interpretation of the student exemption has purportedly been inconsistent.”

It is by no means a foregone conclusion that the Supreme Court will resolve the question of the proper deference standard, as there are many ways to resolve the ultimate question of the applicability of the FICA exemption without having to decide on a deference standard. Nor is it as clear as the government would like that Chevron did or should supersede Muffler Dealers. (If it were, the question probably would not still be open 26 years after Chevron was decided). The IRS is often in an adversarial relationship with taxpayers; it has an inherent fiscal interest in interpreting the Internal Revenue Code in a way that maximizes tax revenues. Therefore, there are good reasons for the courts to afford less deference to Treasury regulations that would determine the outcome of tax disputes than to regulations of more neutral agencies that are merely administering a federal statute. Can the government really respond to an IRS defeat in court by promulgating a regulation to overturn the decision and then expect the courts to defer to that regulation without taking any account of how it came to pass? Or can it reverse a regulatory interpretation simply because it determines that the reversal will benefit the public fisc, without paying some price in terms of judicial deference? Perhaps the Supreme Court will answer those questions soon.

Oral argument in the Mayo Foundation case is scheduled for November 8.

As we previously reported, a district court in Michigan disagreed with the Federal Circuit’s decision in CSX Corp. v. United States, 518 F.3d 1328 (2008) (opinion linked here), and held that severance payments paid to employees pursuant to an involuntary reduction in force are not “wages” for FICA tax purposes. The employer, Quality Stores, has now filed its answering brief in the Sixth Circuit defending the district court opinion and addressing the arguments made by the government in its opening brief, and the government has filed its reply brief. (The briefs are attached below.)

The employer’s main argument is a textual one, based on the interplay between the FICA and income tax withholding provisions of the Code. Asserting that “wages” should mean the same thing in both sets of provisions, the employer relies on Code section 3402(o), which states that “supplemental unemployment compensation benefits” should be “treated as . . . wages.” Implicit in this provision, the employer asserts, is the proposition that such “SUB pay” would not otherwise be wages. Since the severance payments are encompassed within “SUB pay,” it follows that they are not “wages” for FICA purposes. (FICA does not contain a provision analogous to section 3402(o)).

The Federal Circuit in CSX had rejected the logic of this argument, reasoning that section 3402(o) might imply that some SUB pay is not “wages,” but not that all SUB pay is not “wages.” In addition to that relatively narrow argument, the government has suggested more broadly that the meaning of “wages” in the income tax withholding context “has no bearing” on its meaning in the FICA context. The Federal Circuit did not fully embrace that suggestion in CSX, stating that “we disagree with the government’s argument that after 1983, the term ‘wages’ in FICA must be interpreted without reference to the same term in the income tax withholding statutes.” In its reply brief in Quality Stores, the government focuses primarily on a narrower argument that accords with the Federal Circuit’s approach, contending that section 3402(o) was addressed only to the subset of SUB pay that had been exempted from withholding by certain Revenue Rulings. Because the payments in this case would not fall within those Rulings, the government reasons, section 3402(o) is irrelevant.

The employer also argues that the Sixth Circuit is bound by the Supreme Court’s decision in Rowan Cos. v. United States, 452 U.S. 247 (1981), to treat SUB pay the same for income tax withholding and FICA purposes. The government responds that Rowan cannot have that precedential effect after Congress overruled it and passed the “decoupling provision.”

With the briefing now concluded, the parties await the assignment of a date for oral argument, which will likely occur in the winter. The briefs are complex, and it remains to be seen whether the Sixth Circuit will immerse itself deeply in the issue or, instead, give considerable deference to the decision of its sister circuit in CSX.

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Miller & Chevalier was founded in 1920 as the first federal tax practice in the United States. For nearly 95 years, the firm has successfully represented the most sophisticated corporate clients in all facets of federal income taxation. Miller & Chevalier’s Tax department serves clients headquartered throughout the U.S. and around the world and, over the past several years, has represented approximately 30 percent of the Fortune 100 and more than 20 percent of the Global 100. Our clients come to us to solve the thorniest of tax issues, and we have litigated many of the most significant tax cases on record.

The Tax Appellate Blog is intended to be a resource for information on important tax cases under consideration in the appellate courts. It will feature insightful commentary on the issues and provide a dedicated site for following the progress of these cases.

Authors

Steve Dixon is a Member in the Tax Department at Miller & Chevalier. He specializes in controversy and litigation, representing taxpayers in the Tax Court and Federal courts.

Laura Ferguson is a Member of the Supreme Court and Appellate Litigation Group at Miller & Chevalier and has successfully briefed and argued six cases at the U.S. Courts of Appeals in the past two years. Ms. Ferguson also has extensive experience litigating complex, high-stakes tax cases at the Tax Court and federal district courts.

Alan Horowitz is the former Tax Assistant to the Solicitor General at the Department of Justice, where he briefed and argued numerous tax cases in the Supreme Court. He is currently the head of the Supreme Court and Appellate Litigation Group at Miller & Chevalier.